The only investments I hope my kids ever make...

The only investments I hope my kids ever make... The two secrets of successful insurance investors... Bull or Bear?... Why I laugh at poor people...

I have a very simple question for today's Digest. If you were going to limit all of your investments to only one sector of the economy – only one type of business or one kind of stock – what would you buy?

We've come to believe that, for outside and passive investors (common shareholders), there are really only three sectors that offer truly extraordinary rates of return and that don't require taking any material risk. Let me be clear about what I mean. There are three sectors of the economy where companies can establish and maintain a truly lasting competitive advantage and outside investors can identify attractive values.

As I teach my children about investing, I will focus almost entirely on examples from these three sectors. And truly... I will spend most of my time explaining only one business to my children. If they come to understand this business thoroughly, I know, with a reasonable amount of saving discipline, they will be financially secure by the time they are 30 years old... and wealthy long before they reach 50.

As part of my nine-day Digest series (while Sean Goldsmith is on vacation), I'm going to spend a full day explaining what we see in these sectors of the stock market. I want to show you why the investment returns are so incredibly good over the long term. I want you to know how to think about these businesses... how they work... and know a few simple keys to making great investments in these sectors.

I promise... this is all far easier than you're imagining right now. And like I told you yesterday, I'm sure you'll want to print these Digests, put them in a binder, and refer to them from time to time.

Let's start with this chart.

This chart shows four of the best-managed insurance companies in the United States. Company No. 1 got its start insuring contact lenses and now it mostly insures things that other companies won't touch, like oil rigs and summer camps. It's a pretty small public company, worth about $2 billion.

Company No. 2 was founded by a Harvard graduate just out of college about 40 years ago. It is still mostly a family business (even though it has public shareholders and is worth $6 billion). It insures almost anything commercial, from yachts to elevators.

Company No. 3 is one of the world's largest insurance companies. It insures everything – homes, cars, boats, weddings (yes, weddings), etc. It is worth $33 billion.

And Company No. 4 is a major global company that (again) insures virtually anything and is worth $22 billion.

You might think, outside of being in the insurance industry, these companies have almost nothing in common. Some are very small and insure essentially niche items. Others are huge, operate globally, and insure virtually anything. Yet to us, these companies look nearly the same: They are among the very best underwriters in the world.

That means these insurance companies almost always demand more in insurance premiums than they will end up spending on insurance claims. As you will soon learn, there's probably nothing more valuable in the financial world than having the skill and the discipline to underwrite insurance profitably.

Over the long term, all of these companies have generated returns that are more than double the S&P 500. They did so without taking any risk – something I'll explain more fully below. And... here's the best part... their success was both inevitable and repeatable. These are not "lucky guesses" or fad-driven product sales.

One of our overriding goals at Stansberry & Associates Investment Research is to give you the knowledge we'd want to have if our roles were reversed. Knowing what I know now about finance, I wouldn't have gotten into the investment newsletter business. I would have gotten into insurance.

There is nothing more valuable we can teach you than understanding how to invest in good insurance companies. And with the legwork we do for you in our Insurance Value Monitor (a part of our Stansberry Data service), it's as easy as pointing and clicking. If a company passes our tests and you can buy it at the right price... you can be next to 100% sure that the investment will produce outstanding returns. It's like painting by numbers. Only it will make you rich.

Let me say it one more time... I believe if individuals would limit themselves to only investing in insurance companies – and no other sector – they would greatly increase their average annual returns. We don't believe that's true of any other sector of the market.

There's a simple reason for this. If you'll think about it for a minute, it should become intuitive. Here's why insurance is the world's best business: Insurance is the only business in the world that enjoys a positive cost of capital.

In every other business, companies must pay for capital. They borrow through loans. They raise equity (and must pay dividends). They pay depositors. Everywhere else you look, in every other sector, in every other type of business, the cost of capital is one of the primary business considerations. Often, it's the dominant consideration. But a well-run insurance company will routinely not only get all the capital it needs for free, it will actually be paid to accept it.

I want to make sure you understand this point. All of the people who make their living providing financial services – banks, brokers, hedge-fund managers, etc. – all of them pay for the capital they use to earn a living. Banks borrow from depositors, investors who buy CDs, and other banks. They have to pay interest for that capital. Likewise, virtually every actor in the financial-services food chain must pay for the right to use capital. Everyone, that is, except insurance companies.

Now just follow me here for a second... Insurance companies take the premiums they've collected and they invest that capital in a range of financial assets. Assume, just for the sake of argument, that they earn 10% each year on their premiums. (That is, they make 10% on their underwriting.) And assume they invest only in the S&P 500… What do you think the average return on their assets will be each year? In this hypothetical example, their return would be 10% plus whatever the S&P 500 returned.

In reality, of course, few insurance companies can make such a large underwriting return. And few insurance companies invest a large percentage of their portfolio in stocks. Most stick to fixed income to make sure they can always pay claims. But the point remains valid. By compounding underwriting profits over time, year after year, into the financial markets, insurance companies can produce very high returns.

And here's the best part: Insurance companies don't really own most of the money they're investing. They invest the "float" they hold on behalf of their policyholders. Float is the money they've received in premiums, but haven't paid out yet. Underwritten appropriately, this is a risk-free way to leverage their investments and can result in astronomical returns on equity over time.

Just look at insurance company No. 1 in the chart above. It has produced eight times the S&P 500's long-term return. Can you think of any investor, anywhere, who has done anything like that? There isn't one. That kind of performance was only possible because, using a small equity base, the firm has invested very profitably underwritten float into solid investments, year after year.

Do you like paying taxes? Well, you won't like insurance stocks, then. They have huge tax advantages. Insurance is, far and away, the most tax-privileged industry in the world. Many of their investment products are totally protected from taxes. And their earnings are sheltered, too. Insurance companies don't have to pay taxes on the cash flow they receive through premiums because, on paper, they haven't technically earned any of that money. It's not until all of the possible claims on the capital have expired that the money is "earned."

So unlike most companies that have to pay taxes on revenue and profits before investing capital, insurance companies get to invest all of the money first. This is a stupendous advantage. It's like being able to invest all of the money in your paycheck – without any taxes coming out – and then paying your tax bill 10 years from now.

I realize that I can't make you (or anyone else) actually invest in insurance stocks. And I know that no matter what I say, most of you – probably more than 90% – never will. It's a tough industry to understand, filled with financial concepts and tons of jargon. But there are two reasons the smartest guys in finance wind up in insurance, one way or another...

First, it pays the best. And second, it takes real genius to understand. But... my goal is to make it so easy to understand and follow that any reasonably diligent subscriber can do so. I'd urge you to read the March 2012 issue of my Investment Advisory newsletter for more details about how we analyze insurance stocks.

In the meantime, I want to simply show you the one number you've got to know to invest safely and successfully.

Normal measures of valuation don't apply to insurance companies. Why not? Because regular accounting considers the "float" an insurance company holds as a liability. And technically, of course, it is. Sooner or later, most (but not all) of that float will go out the door to cover claims. But because more premiums are always coming in the door, float tends to grow over time, not shrink. So in this way, in real life, float can be an important asset – by far the most valuable thing an insurance company owns. But there's one important catch...

Float is only valuable if the company can produce an underwriting profit. If it can't, float can turn into a very expensive liability.

That's why the ability to consistently underwrite at a profit is the key – the whole key – to understanding what insurance stocks to own. Outside of underwriting discipline, almost nothing differentiates insurance companies. And they have no other way to gain a competitive advantage. Warren Buffett – who built his fortune at Berkshire Hathaway largely on the back of profitable insurance companies – explained this in his 1977 shareholder letter:

Insurance companies offer standardized policies, which can be copied by anyone. Their only products are promises. It is not difficult to be licensed, and rates are an open book. There are no important advantages from trademarks, patents, location, corporate longevity, raw material sources, etc., and very little consumer differentiation to produce insulation from competition.

Thus, the basis of competition between insurance companies is underwriting. That is... to be successful, insurance companies must develop the ability to accurately forecast and price risk. And they must maintain their underwriting discipline even during "soft" periods in the insurance market when premiums fall.

In our Insurance Value Monitor, we track nearly every major property and casualty insurance company in the U.S. and in Bermuda (where many operate to avoid U.S. corporate taxes completely). We rank every firm by long-term underwriting discipline. We've done the legwork for you. All you have to do is know what price to pay. So if normal accounting doesn't apply for insurance stocks, how do you value them? Again, we went to the master, Warren Buffett, to see what he was willing to pay for very well-run insurance companies.

Bryan Beach, our lead insurance analyst, found data on three of Buffett's biggest insurance purchases. In 1998, he bought General Re for $21 billion, which added $15.2 billion to Berkshire's float and $8 billion in additional book value. So Buffett paid $0.94 for every dollar of float and book value.

Before that, in 1995, Buffett bought 49% of GEICO for $2.3 billion, which added $3 billion to Berkshire's float and $750 million in additional book value. So Buffett paid $0.61 for every dollar of float and book value.

And way back in 1967, Buffett paid $9 million for $17 million worth of National Indemnity float. That's $0.51 for every dollar of float. Looking at these numbers, we expect to pay something between $0.75 and $1 for every dollar of float and book value.

In short, there are two fundamental rules to investing in insurance stocks. Rule No. 1: Make sure the company earns an underwriting profit almost every year, no exceptions. And Rule No. 2: Never pay more than 75% of book value plus float.

Most investors will never be able to make these investments because they don't understand why underwriting discipline is so critical. And they have no ability to accurately calculate float. Again, we've done all of the hard work for you in our Insurance Value Monitor that's a part of our Stansberry Data service. We update the information monthly, and it's available for free to our Alliance members and certain groups of Stansberry's Investment Advisory subscribers. If you're interested, please give our customer service staff a call at 888-261-2693. Doing so could realistically make you rich.

Tomorrow... another sector of the stock market that can genuinely make you rich and is easy for outsiders to master.

New 52-week highs (as of 6/17/2014): Activision Blizzard (ATVI), Chesapeake Energy (CHK), Comstock Resources (CRK), Carrizo Oil & Gas (CRZO), Chevron (CVX), Freehold Royalties (FRU.TO), Halcon Resources (HK), iShares Dow Jones U.S. Insurance Fund (IAK), Integrated Device Technology (IDTI), SPDR S&P International Health Care Fund (IRY), Microsoft (MSFT), ProShares Ultra Technology Fund (ROM), RPM International (RPM), Sabine Royalty Trust (SBR), Skyworks Solutions (SWKS), Triangle Petroleum (TPLM), Targa Resources (TRGP), W.R. Berkley (WRB), and Alleghany (Y).

We didn't get much vitriol in the mailbag, despite my sincere requests. We did get about a dozen questions asking nearly the same thing: If you really expect a market crash, why are you still recommending we continue to buy stocks? Answers below.

Again... we learn more from our critics than our friends. Be sure to let me know, personally, how we've let you down: feedback@stansberryresearch.com.

"I'm sure I'm not the only one who's getting quite confused by the S&A market outlook and overall advice. It's apparent you have been on the opposite side with Doc and Steve for some time now regarding the market direction and forward prospect. In fact, you've been boldly predicting not just a stock correction, but a CRASH since 4Q of 2013. You've even indicated you've liquidated your own personal stock portfolio in preparation of the imminent carnage.

"Well, we're now in June and needless to say, you've been humbly and soundly beaten by Doc and Steve so far, as the broader market has continued to march upward. Sure, a lot of the frothy names with insane valuation have suffered a haircut recently, but I'm certain they don't represent the entirety of your crash thesis. The interest rate remains low, the economy is slowly recovering, and the S&P's earnings multiple isn't out of whack on a historical basis. Add to that the AAII sentiment indicator showing the public's low bullish reading, so where's the proverbial final nail in the coffin? If the market is in the habit of punishing as many investors as possible, then how can this be the top when the mom-and-pop crowd is still on the sidelines?

"If a CRASH is indeed around the corner as you've said, then what's the benefit of holding something just to lose less than others? Wouldn't it be much more prudent to wait to buy these same quality businesses AFTER the crash? It's true that no one (not even S&A) has a crystal ball to predict the future. At the same time, I shouldn't be left with the notion that your ability to predict the future is no better than mine. Your collective insight, expertise, and prowess should give you that edge, but that also doesn't mean you can talk out of both sides of your mouth. I suppose, though, that if you lean on one side of the market long enough, you'll eventually be proven right (you know what they say about a broken clock). I don't want to think of you as a broken clock." – Paid-up subscriber Charlie W

Porter comment: I'm chuckling at your obvious disappointment that I'm not better at predicting the future than you. No, indeed, I cannot predict the future. But my knowledge of and experience in the financial markets has given me a substantial edge when it comes to market judgment. As a result, I'd rather buy stocks when they're cheap – when other investors don't want them – than I would buy them after a huge run up, when they're at all-time highs. That's especially true when junk bonds are yielding less than 5% – which is pure insanity in my view. This will certainly end badly. I hope to have plenty of capital on the sidelines when it does.

Yes, last June, I warned that the risks posed by bonds and threats to the U.S. dollar were grave enough to put equity investors at risk. You may recall that we took profits at the time across half a dozen stocks whose businesses are speculative and/or whose share price had provided us with substantial gains.

So far, this has been the wrong call.

Many of the stocks we sold then – Cheniere and MGM, for example – have continued to soar. The corporate bond market is back to its previous highs. And junk bonds are once again yielding less than 5%. Clearly, my ability to forecast a top in our market is not perfect. And just as clearly, Sjuggerud and Doc have been far more astute with their market view.

Nevertheless, I don't regret urging caution. Yes, we have taken some losses (small ones), while shorting seven stocks to hedge our portfolio. If the market goes higher, this hedging strategy will probably tax our performance. But when the bear market does arrive, it will allow us to garner significant gains that will replace the money we will lose as our long positions decline to their trailing stop losses.

You're right. If we knew precisely when the market would top, we would only have to hold cash and wait. But nobody has a crystal ball. The best we can hope to do is to make hay while the sun shines, while hedging our bets significantly. And that's what we've done.

Meanwhile, since last June, I've still been able to find attractive and safe stocks for us to own that should do well in an inflationary crisis – like Chesapeake Energy, which is pioneering shale oilfields. It's up about 45% from where we recommended it. Likewise with our propane-export stock Energy Transfer Partners (up 68%). We also have healthy gains in oil firm Anadarko and natural gas distribution company National Fuel Gas Co.

And to protect against inflation, I recommended buying the gold stock NovaGold. Yes, it's volatile. And yes, it's speculative. But if there's a bona fide dollar crash, this stock will soar. And it already has started to do so. We're up nearly 90% since we recommended it in November despite a big pullback recently in the shares.

I could go on...

In short, we've done well with stocks that are designed to perform well in a bear market. Stocks like tobacco leader Lorillard and "poor people" businesses like Rent-a-Center and Dollar General. So... you're correct that I made a "crash" warning too soon… but I don't believe it's fair or accurate to say I've "talked out of both sides of my mouth."

I remain concerned about the level of the U.S. stock market. And I'm even more worried about the bond market, which, thanks to the Fed, has lost all touch with reality. As I don't expect zero inflation and zero interest rates for long, it's natural that I'd be very cautious about putting new savings to work in stocks. My caution has been fully expressed in our portfolio, which has been carefully designed and protected by stop losses and hedge positions.

Happily, we have done very well with this strategy. And that's the real objective, isn't it?

"Porter, I'd just like to give you some feedback from a longtime Alliance member. Reading the Digest today and saw the following post: 'Your investment advice has been spot on at times, but your investment choices have, for me, been spot wrong. I have lost more money from your advice then I've gained... '

"That pretty much sums it up for me too. Having access to everything has really been a challenge for me. I find that I overtrade – trying constantly not to miss the next big move. Then, when I do have some profit I tend to take it quickly and move on to the next recommendation. Months down the road, I'll see where such and such had a 100%-plus gain – of course that's the position I closed out with the small profit. The roundtables (stansberryradio.com) have helped where you get the best ideas from a few of your analysts. I also really liked this latest Digest with the best ETFs to buy (limited number of choices for me). Fortunately, I already have the SYLD and USCI – think I'll keep them and let them run (yeah, easier said than done). Just a few thoughts." – Paid-up Alliance member Chris

Porter comment: I can completely understand this challenge. We publish research to help investors find the investments that suit their needs. We don't offer any individual coaching to help determine which investments are right for you personally. And that's where a lot of subscribers end up making mistakes. Here's what we can do to help:

Read the S&A 16 when we publish it every quarter. This is for S&A Alliance members only and it is, I believe, the most valuable service we offer. Here, we put together a balanced portfolio that's reasonably diversified (16 positions), giving you four value stocks, four growth stocks, four income plays, and four "macro" investments. This shows you how we'd construct our mutual-fund portfolio, if such a fund existed. You don't need to mimic us directly, but if you don't know where to start, this is a good place to begin. Then, each quarter, look at what we're emphasizing in our S&A 16 and consider how it compares with your portfolio. Maybe you need more income. Maybe you want to take more risk (I wouldn't recommend it). But at least you've got a touchstone to consider so that you don't get too far from "par."

Next, always use the same position size. I'd recommend something between 4% and 6% of your portfolio for new positions. Never more than this. Don't play favorites. If you have 5% in each position, at most, you could have 20 positions. That's about all an individual investor can reasonably keep tabs on. Leaving 20% in cash (always wise), that's still 16 stocks.

Don't try to fill your portfolio from scratch. Take a year... or more... and only buy the stuff that seems safe and you thoroughly understand. Read that again: Only by stuff that you thoroughly understand.

Always let your winners run. Always cut your losses. Use www.tradestops.com to help manage your risk.

From time to time ... but only very rarely... put on a double position (up to 10%). Only do this when an analyst you really trust says that the investment is so safe that you can put on a bigger position. For example, my recent Lorillard recommendation. But never use a large position size with a risky bet. Never, ever, ever.

"Porter... There is a part of you I find repugnant... listening to you chortle about selling furniture to fools on your podcast almost made me nauseous. I recognize their right to make bad choices, and grudgingly recognize your 'right' to take advantage. But I don't like it.

"If the way to wealth is on the backs of others, I'll hang with the poor. This is a part of me that makes the whole of investing and listening to investors very difficult. Seems that not too popular in the investment world is the motto 'do no harm.'

"There are many 'good' investments I could never stomach. I believe money is a powerful thing – with which I can change the world for the better. Or for the worse! I am a strong proponent of personal social welfare. Not gov't subsidy of everyone, but individual kindness for sure. (I actually believe in gov't welfare programs, but that's a different discussion.)

"My point here is – one of (if not the) most endearing features of humanity is our capacity for compassion, brotherhood (no gender implied here). Not absent in the animal world, but we really have a corner on teamwork, pulling each other up, calling forth the best in each other. And I believe the smart ones, who can easily take care of themselves, have a societal obligation to others. Not necessarily to gift them, but to inspire and educate, at the very least.

"Funny thing – I hear in your voice, just like my old man, that you are that kind of a guy, in spite of views I call 'right wing.' Now maybe by broadcasting your view on the furniture-loan business you are actually giving people a chance to see how foolish those purchase/loans are. Guess I'll hold that thought and take you off my dartboard (don't really have one)." – Paid-up subscriber 'No Name'

Porter comment: I've spent most of my adult life working diligently to give the average investor some of the advantages that professionals enjoy. I consider my work a serious matter. I strive to make a positive impact on the lives of my subscribers, so that I, in turn, can make a positive impact on the lives of my partners, employees, family, and community. I take personal responsibility for my company, its products, its people, and the results we achieve for our subscribers. I always will. That's why I'm dedicated to providing excellent customer service – including generous refunds for anyone who isn't satisfied. And that's why we diligently measure our results each year with our Report Card.

These aren't easy things to do, which is why so few, if any, of our competitors do them. But by doing these things, I've built a loyal subscriber base of nearly half a million people around the world. They wouldn't stay with us if we weren't helping them become better investors, if I wasn't helping them make money.

Likewise, I've made my partners and many of my employees very wealthy. I've paid hundreds of millions in taxes. I don't discuss my charitable giving, but it has been significant, too. Considering the value I've created in the last 20 years for all of these people, what I've taken for myself is merely a pittance.

Thus, I can't understand how anyone could say that I've created my wealth on the backs of others. I've done the opposite. Whenever it was necessary, I put all of these people "on my back" and I carried them. Ask subscribers who made it through 2008 and 2009 by sticking with us. Ask employees I've mentored and trained. Ask my partners – some of whom had nothing before they joined with me.

Sure, I love what I do and I've enjoyed almost every day of the last 20 years. But I'm also certain that "hanging with the poor" would have been a lot easier than the path I've chosen.

So yes, I laugh... a sad and ironic laugh... at the bad decisions that poor people make. I'm not ashamed to say so. I laugh because I know these people are not going to get what they expect. They're going to get what they deserve.

Like when the poor woman waiting in line for the welfare check tells the reporter she's happy Obama was elected because he was going to "pay my mortgage." Here's an adult that knows so little about the world that she doesn't understand the first thing about taking care of herself or being responsible for her own debts. What else can you do but laugh? You think you can help that person? That's even funnier. It's like what comedian Ron White says: "That's like trying to train a bird dog not to eat chickens." It ain't gonna happen. And only a fool would try.

So I laugh because I know, no matter what I do, the poor will always be with us. There will always be some people who are incapable or unwilling to delay gratification, work hard, think for themselves, and be responsible for themselves.

Sure, someone has to take care of some of these people, who truly can't take care of themselves. And that's where a lot of my taxes go. But that will never be my job. Why not? I don't believe doing that job makes you noble. I think taking care of most of these people is what enables them to remain poor. If you want to do right by these people, tell them if they don't work, they won't eat. And what would happen then?

A whole lot of overpaid charity workers and a lot of politicians would be out of a job and out of power. There's a whole industry that exists to keep people poor. And it ain't the folks renting furniture. It's the politicians and phony charities that keep all of the money and power. It's these people who really understand what poverty is all about.

You might not like this... but the poverty industry is fed and kept alive by people like you, who have nice intentions, but don't have the first clue about why so many people are poor in America today.

"Porter, nobody, and I mean nobody, who either didn't see Baltimore, much less live in it, in the '70s, as you and I did, will have any idea what your comment about living in a $250/month walk-up on North Avenue really means. I 'lived' in an efficiency apt. behind a parking garage at 34th and St. Paul just outside a neighborhood called Waverly, which in the '40s and '50s was probably a nice place, but by the time I got there, it was what we called a 'hole.'

"It was in Baltimore that I bought on the street and carried illegally my first firearm at the tender age of 21. It was two of the most challenging years of my life and caused me to terminate my graduate education at JHU early, and run home to Louisville, KY. It wasn't all bad, of course, but the stories I tell people today of that time still leave people incredulous. I returned in 1998 and attended a ballgame at Camden Yard and saw the 'renovated' downtown. To me, it was lipstick on a pig. I admire your work and wish you continued success." – Paid-up subscriber PM

Porter comment: Well... Just to be clear... I didn't move to Baltimore until 1998. But yes, there were still plenty of mean streets here then (and still are today). Automatic gunfire wasn't uncommon on my block. That was a very good motivator for me. Don't be poor.

"Porter... I am not sure how long I have been a subscriber, but it's been less than two years. I do not agree with all of your opinions. From time to time, I tire of being bombarded with 'buy now, get a great secret, and even better deal.' So I can relate to some of yesterday's comments. However, I also don't agree with my wife. I've been married for almost 32 years. With that in mind here's straightforward feedback...

"I read almost everything you send, sometimes several times. I learned and studied to fit the analysis from you and your partners into something that I thought was right for me – I waited almost a year before I integrated your advice into my stock purchase plans.

"Yesterday, I looked at one of the accounts that has been reorganized solely based on ideas from your organization. I did this to be able to see clearly how well I could work with the analysis from your firm. I started buying in October 2013 and made my last purchase in March 2014. As of yesterday's market close, the group of stocks is up 26%. The average holding period is just shy of 23 weeks. I believe the S&P 500, Dow, and Russell 2000 are up roughly up 7.2%, 3.7%, and 3.4% respectively over the last 26 weeks.

"I really don't care what all the haters and naysayers have to say, except for entertainment. You and your partners are my partners. I look forward to your ideas. The input you provide has been invaluable.

"Yeah, we'll disagree, and I'll tire of all the selling (it's your business). But, in my opinion, it's obvious the results speak for themselves." – Paid-up subscriber Carl

Porter comment: That's the kind of feedback I wish every single customer could offer me: "I studied your work. I took what was right for me. I was thoughtful and cautious in my execution of your ideas. You've helped me make great investments." By the way, Carl, congrats on your 32 years of marriage. All of my partners are married... and nearly all of us to our first wives.

Regards,

Porter Stansberry
Baltimore, Maryland
June 18, 2014